The unspeakable in pursuit of the inedible
– Oscar Wilde’s definition of fox hunting.
To read the financial media after Goldman Sachs announced its results for the second quarter felt rather like reading about the chap who turned up wearing his birthday suit to a funeral. America was in mourning for its lost economy, bust through the shenanigans of the Fed and millions of greedy, vacuous Americans and yet, here was a firm – a bunch of financial men for goodness sake – who dared, nay even boasted, about their ability to make money. Surely, fumed the great unwashed, such a travesty cannot be allowed to happen in the Land of the Obama-magic?
First perhaps, a quick background check: your columnist was never in the employment of Goldman Sachs, directly or indirectly. Indeed, my record as a columnist shows more than an ordinary slant against the firm, in the sense that I simply do not believe the accounting logic employed by the firm that is behind much of the financial magic. My record will also show a consistent spewing of vitriol against former employees of Goldman Sachs (my diatribes against Hank Paulson being particularly familiar to regular readers of Asia Times Online) who found jobs in the United States and with governments around the world, in effect forming a micro group that guides global economic policy on a rather grandiose scale.
All that though, is firmly in the class of debates between opposing capitalists; put a couple of socialists in our midst and we capitalists do tend to strike out together against the common enemy; much like a pack of dolphins will attack a Great White shark. Thus it is that I find it both correct and timely to write an article defending the profits of Goldman Sachs, this quarter in particular.
Last week, I wrote about the sheer idiocy of the many pronouncements made by New York Times columnist Paul Krugman. A day after Goldman Sachs posted its bumper profits of US$3.44 billion for the second quarter, in the process setting aside some $1.65 billion as bonuses for its own employees, Krugman was at it again:
The American economy remains in dire straits, with one worker in six unemployed or underemployed. Yet Goldman Sachs just reported record quarterly profits – and it’s preparing to hand out huge bonuses, comparable to what it was paying before the crisis. What does this contrast tell us?
Reading that opening paragraph, for a second (and just a fleeting second mind you), I thought perhaps Krugman would be on to something new – that Americans being a resourceful, innovative bunch of people would always use their skill sets to come out of any crisis; and that Goldman Sachs could well be seen as the appropriate role model with which to do so … sadly, that wasn’t to be, as Krugman was instead wearing his Lenin glasses, and really had no time for profiteering capitalists, as he calls them:
First, it tells us that Goldman is very good at what it does. Unfortunately, what it does is bad for America. Second, it shows that Wall Street’s bad habits – above all, the system of compensation that helped cause the financial crisis – have not gone away. Third, it shows that by rescuing the financial system without reforming it, Washington has done nothing to protect us from a new crisis, and, in fact, has made another crisis more likely.
Krugman lost me on the first point: Goldman Sachs makes most of its money trading; that is, selling stuff for more than it costs to buy it. Almost by definition, that cannot be bad for anyone unless of course both the buyers and sellers that Goldman caters to are preternaturally stupid. The latter issue is debatable, but not quite what Krugman is criticizing here, so we can move on.
On his second point, I am not sure what it is that Krugman is criticizing exactly – that people who make money shouldn’t be paid for their effort; or that people who make a lot of money shouldn’t be allowed to make more of it. Both are dumb arguments and generally not worth debating.
It is on the third point that Krugman actually makes sense, and ironically in so doing ends up contradicting his earlier opposition to the US (George W. Bush) government letting big firms like Lehman Brothers fail (self-contradiction without shame is an Orwellian talent that communists possess in great measure and one that Keynesians will have to brush up on now that they are in charge of the world’s largest economy).
When the US Federal Reserve and Treasury rolled out blank checks galore to the rescue of banks, along with the governments of the United Kingdom and the rest of Europe, they embarked on a series of moves that guaranteed the persistence of moral hazard for another two generations. Bankers had become the most protected species on the planet (see The New Brahmins, Asia Times Online, March 29, 2008). Fear about failing banks led governments into a series of protective steps that were bound to be capitalized on by at least one bunch of intelligent people, if not the next.
In the event, Goldman Sachs fully tapped the government-guaranteed funding market, and issued for itself a lot of cheap long-term financing; that was in turn ploughed back into the purchase of deeply distressed securities, many of which were trading below their statistically implied probability of defaults and asset recoveries. The end result was electric – a massive rally in the prices of such securities, which acted as a growth driver, pushing up its fixed income to three times what it was this time last year. (See Easy bets with other folks’ cash, Asia Times Online, May 23, 2009 for more on this trend.)
Krugman has always held that allowing Lehman Brothers to fail was a monumental mistake made by the George W. Bush administration. In contrast, the bankruptcy of Lehman has showed a lot of positive results: talented people working for Lehman were snapped up by other banks, the company’s useful assets and franchises were purchased by other firms and in general, the unwind of its asset book to pay for excess liabilities has gone to plan. In contrast, firms that have been saved by the US (and other) governments have shown no particular urgency to get anything fixed: witness last week’s indifferent results from the likes of Citibank and Bank of America where it was one-off (extraordinary) items that helped to push profits rather than useful, regular, recurring stuff as in the case of firms that went to the brink and came back (such as Goldman Sachs and JP Morgan).
Somewhere towards the end of his article, Krugman finally gets to the major reason why he is upset with the firm:
Goldman’s role in the financialization of America was similar to that of other players, except for one thing: Goldman didn’t believe its own hype. Other banks invested heavily in the same toxic waste they were selling to the public at large. Goldman, famously, made a lot of money selling securities backed by subprime mortgages – then made a lot more money by selling mortgage-backed securities short, just before their value crashed. All of this was perfectly legal, but the net effect was that Goldman made profits by playing the rest of us for suckers.
Much like John Maynard Keynes himself, who famously misstated economic theories and laws that he then “disproved”, Krugman is twisting facts here. While it is true that Goldman Sachs bet against the subprime mortgage-backed securities business, it was itself a minor player in the sector; indeed its short positions were used by bigger rivals to package new securities that were sold to European banks; a turn of events that left Goldman Sachs dangerously exposed to significant trading losses had mortgage-backed securities NOT fallen off the cliff as they did in 2007.
Then, Krugman caps himself in Keynesian glory with this statement:
What’s clear is that Wall Street in general, Goldman very much included, benefited hugely from the government’s provision of a financial backstop – an assurance that it will rescue major financial players whenever things go wrong … You can argue that such rescues are necessary if we’re to avoid a replay of the Great Depression. In fact, I agree. But the result is that the financial system’s liabilities are now backed by an implicit government guarantee.
Having engineered an idiotic system that forces government (read: taxpayers) to shoulder the burdens of a dysfunctional financial sector, Keynesians and their companions are now up in arms that someone should dare to make money off their largesse.
How about explicit non-guarantee?
What the world’s Keynesians do not understand is the results of their own actions. In particular, when you issue blanket guarantees, there is by definition NO intent to reform; therefore banks and other recipients of largesse simply sit around and try to make money on what they have rather than on what they should be doing correctly.
This is the main reason that bank balance sheets are still swollen and no meaningful de-leveraging has occurred.
If the entire world’s Keynesians were really disgusted by the prospect of Goldman Sachs and its companions on Wall Street making billions of dollars, they have to simply learn to walk away – admit that it is generally a mistake to issue blanket guarantees, and then go ahead and sever the umbilical cord with the world of finance.
Here is what that will cause: inevitably, one or two of the world’s largest banks will fail; governments should step in and rescue retail depositors, but leave everyone else hanging by the thread of their now-worthless securities where the payout will depend on the liquidation value of the firm’s assets.
Immediately, all of the world’s financial firms will look to improve the quality of their asset books and generally eschew assets that are illiquid and/or longer-term (exactly what happened in the fourth quarter of last year). When this happens and the price of these risky asset goes to new lows, financial firms that are well-funded and stocked with truly intelligent people – and perhaps Goldman Sachs will be one of these firms – will find it quite profitable to engage in those lines of business, and particularly, on their own terms.
Overall, the system will be forced to decrease its leverage, and thereby force a contraction of economically useless activities. As the author Ayn Rand put it so well in Atlas Shrugged (a novel about the politics of the rich being forced to pay the indolence of the poor, a topic I shall return to in a future article), it was never the job of governments to shoulder the burden of companies simply because they were considered too big to fail. Keynesians do not have the courage to tell Atlas what they should: go ahead buddy, shrug.